Governments and central banks use policy tools to stabilize the economy and pursue goals such as full employment and stable prices. Fiscal policy works through government spending and taxation and is administered by the legislative and executive branches. Expansionary fiscal policy, increasing spending or cutting taxes, boosts aggregate demand during recessions. Contractionary fiscal policy, reducing spending or raising taxes, cools an overheating economy and helps contain inflation.
Monetary policy operates through the central bank's control of money supply and interest rates. In the United States, the Federal Reserve conducts monetary policy, supervises banks, maintains financial stability, and provides banking services to depository institutions. Its principal tools are open market operations, the buying and selling of government bonds to influence bank reserves; the discount rate, the interest rate charged on loans to commercial banks; and reserve requirements, the fraction of deposits banks must hold. By adjusting these levers, the Fed influences borrowing costs throughout the economy.
To analyze how policy affects output and prices, macroeconomists use the aggregate demand and aggregate supply framework. Aggregate demand represents total spending on goods and services at various price levels, expressed as the sum of consumption, investment, government spending, and net exports. Aggregate supply shows total output firms produce at each price level; in the short run it slopes upward, but in the long run it is vertical at the economy's potential output. Shifts in these curves, often induced by policy, drive the fluctuations of business cycles, the recurring pattern of expansion, peak, contraction or recession, and trough that characterizes market economies.